Tuesday, July 7, 2009

How to Profit from the Cup-and-Handle Chart Pattern

An interesting addition to the technical analysis tool set is the Cup-and-Handle chart pattern. It is very much like a bullish 'saucer' or 'rounding bottom' pattern, but provides additional points of entry.

There is no better way to learn about new stock chart patterns than to look at a practical example. I have chosen the 1 year bar chart pattern of Maharashtra Seamless, because it has made a classic, and clearly identifiable, cup-and-handle pattern:-

The stock made a previous high of Rs 328 in Aug '08 before continuing its bear market down move. It finally made a low of 112 in Mar '09, before embarking on a sharp rally with the rest of the market. In the process, it made a 'rounding bottom' bullish pattern.

The stock went all the way up to Rs 325 in Jun '09 - nearly tripling in value from its Mar '09 low. Not unexpectedly, it faced resistance near its previous high, and the first attempt on Jun 5 '09 failed to go past it. Three subsequent attempts on lower volumes also failed.

The stock then entered a corrective downward sloping channel that has taken it towards its 50 day EMA at Rs 250, where it is currently seeking support.

The horizontal line connecting the two tops of Aug '08 and Jun '09 forms the top rim of the 'cup' at Rs 328. The 'rounding bottom' pattern completes the body of the 'cup'. The downward sloping corrective channel is the 'handle' of the 'cup'.

The progress of the 'handle' needs to be closely observed, because it can provide clues to what might happen next. The depth of the cup is a move of Rs 216 (= Rs 328 - Rs 112).

The 'handle' can retrace between a third and a half of the 'cup' depth. That means a retracement of between Rs 72 (=Rs 216/3) and Rs 108 (=Rs 216/2). So, the correction of the 'handle' should stop in the price zone between Rs 256 (=Rs 328 - Rs 72) and Rs 220 (=Rs 328 - Rs 108).

On completion of this corrective move, the stock price should break up wards again. This provides three possible entry points - should you be interested in entering this stock.

1. The first, and riskiest, point of entry is any time the stock goes below Rs 256 - like it has done now. Why riskiest? Because the 'handle' can go below the Rs 220 level and possibly negate any up move for now.

(There are other reasons why you may want to enter now. Rs 250 is a support/resistance level - as can be observed from the chart patterns made in Jul '08 and Sep '08 (supports) and Oct '08 and May '09 (resistances). The 50 day EMA is another likely support. The RSI has entered oversold region.)

2. The second, and less risky, point of entry will be when the stock breaks out upwards from the downward sloping trend line of the 'handle' formation.

3. The third, and safest point of entry will be when the stock moves above the cup rim level of Rs 328.

The Cup-and-Handle stock chart pattern usually shows up as a continuation pattern in a bull phase. In this case, however, it has formed a bottoming pattern. (There are some other stocks that are also showing a similar formation. Curious readers may want to try and find out some of these stock charts, as an exercise.)

An inverse Cup-and-Handle can form in bear phases or at market tops - as a variation of the rounding-top bearish pattern.

Here are some questions for my readers. What do you think about the 'handle' formation? Why is it happening? Is it an 'accumulation' or a 'distribution' pattern? (Just use your common sense, and provide your answers in the 'Comments' link, or email me directly.)

14 comments:

Subhankarji, Thanks for the educative article. I am loving it. :) The handle is the smaller down trend, before the start of an up-move. Clearly, the handle indicates a distribution pattern. Doesn't the RSI indicates a oversold zone and a further down move in the stock price? If yes, the entry point of 220 should be closely watched. In addition MACD is also below the signal line and near the zero level. A cross-over of MACD over the signal line indicates the fall in price. A move of MACD and signal line below zero will confirm the downward trend. I think the move below zero needs to be watched too before entering in the stock. Please correct me if i am wrong.ThanksRishi

First of all, thanks for a practical & detailed analysis. I have been learning all about Technicals going through your posts regularly and must admit that all the posts are superlative.

Now answering your question, with whatever knowledge i have had so far, i feel the scenario you described above follows an accumulation pattern. The reason being the volumes are decreasing (as evident from the rightmost part) as the handle starts forming and going downwards as compared to the right side of the cup. That essentially indicates that there is not enough supply and maybe the selling pressure is reducing. Also the gradual decrease in volume mirrors the decline in price (at the handle phase) suggests the same. Going forward if the volumes start increasing thereby increasing demand, then we can see a breakout as suggested by you as part of Cup and Handle pattern.

Thank you subhankarji for a useful article.I am learning technical analysis from your informative posts.I was busy for few days so I could not posts comments to your recent superb posts particularly the one about long term investing.I will write about it soon.with regards,sujoy

Those who bought near the leading edge of the 'cup' in Aug/Sep '08 are using the recent higher prices to exit at breakeven or a small profit/loss. They are the 'weak' hands'. 'Strong' hands are doing the buying - so this should be an accumulation phase. So Sumanta's observation is the most appropriate.

But tech. analysis is not infallible. We have to wait for an upward breakout to really know.

Though a stock can remain overbought/oversold for long periods, breakout from these zones provide good exit/entry points.

Thanks for your explanation. I had one basic question on identifying and analyzing patterns. A given stock's chart could possibly throw different patterns if viewed over different time periods (e.g. 3 months, 6 months, 1 year etc.).

1.In such scenarios, what are the options to choose which pattern to base the analysis on?

2. Could there be a case wherein two different patterns for the same stock over different time zones conflict each other?

3. Is it always better to go with a pattern with higher time period because of the richness of the data?

A stock or index has three different trends at any time - short, medium and long-term. Some times the trends are in the same direction. But they can be different as well.

It is possible that the chart is showing three different trends in different time frames. That is why I use the 20/50/200 day EMA combination.

Which trend you wish to follow depends on your comfort level as an investor. As a long-term buy-and-hold type of investor, I always prefer longer term charts because it smooths out a lot of the short-term 'noise'.

as of now, mah seamless seems to be in the 2nd "less risky" point in your article. Purely from a technical viewpoint would you suggest it for long term? Given that the index is overheated, don't you think that when a correction occurs the stock may also fall in line with the market. Will that negate the cup and handle formation then. I will do my own fundamental analysis on the stock, but wanted your views. Thanks

The stock made a 'handle' bottom at 230 and broke out of the 'handle' pattern at 250. It is moving up making higher tops and bottoms. On Sensex down days it is holding or moving up - indicating strength due to informed buying.

To be totally sure, one should wait for the 328 level to be cleared. Technically, it is a 'buy' now. If you like the fundamentals, buy a small quantity now, and buy more after it clears 328. Even from this price, it may double in a 3 years time frame.

I am just a beginner at technical analysis and i am learning a great deal through your blogs. I have a doubt regarding retracement levels that you always talk about. Should i consider 52 week high and low to calculate these retracement levels or the latest values from which rise or fall happened or should i also consider previous years too?

I know this would be the longest question anyone would have ever asked you. ;-)

You need not worry about the length of your question, Mansoor. If you have a doubt, express it. I'll try to clarify the best I can.

Retracement levels are calculated from major or intermediate tops (and bottoms). More often than not, these tops (and bottoms) are the 52 week highs (or lows). But it could happen over a longer period. For example, the 52 week bottom in the Sensex was in Mar '09. But the Oct '08 bottom was lower.

How do we know if it is an intermediate or a major top (or bottom)? We usually don't know till well after the fact. If you spend a long enough time applying technical analysis tools, you will start to get the feel about the state of the market, and whether we are nearing a top (or bottom).